Long time lurker, first time poster. I recently had a nice conversation with my sister about investing, and she asked if I could write some of the ideas down. I authored the following. I am looking for any feedback, particularly anything that is wrong, misleading, too much detail, too little detail, etc... I also welcome any stylistic advice, including any help on how to simplify.

She is 26 and has good lifestyle habits: although living in a hcol area and having a modest salary, she has no debt and has saved quite a bit. I therefore don't write anything about lifestyle or living below your means. I also don't write about active management or market timing, as she had no interest in those topics.

Thanks in advance!

I. The Basics

1. Why should I invest? When you put money in a savings account, it grows at a very small rate. But every year things get more expensive (inflation). Thus, the purchasing power of the money in your bank account decreases each year. Investing is necessary so that your savings grow at a faster pace than inflation. Additionally, it is all-but-impossible to save enough money to retire unless your money grows through investment.

2. Should I invest all of my money? No. It is important to have an emergency fund that can help you if you have any unexpected costs. A good goal would be to have one-to-three months of expenses in your savings account.

3. Speaking of retirement, how much money will I need to retire? This answer depends on a few things, such as the rate of inflation, how much you want to spend in retirement, the age you retire, and whether social security continues. Assuming 2% inflation, a desire to spend $60,000 per year (in today’s dollars), that you want to retire in 35 years, and that social security still exists, you will need roughly $1,800,000.

4. What can I invest in? Most people invest in stocks and bonds.

5. What is a stock? A stock is ownership in a publicly traded company, like Facebook, Microsoft, Apple, or General Motors. The benefit of owning a stock is that when the company is profitable it will pay some of its profits to the owners.

6. What is a stock dividend? When a company earns a profit, it can choose to pay a portion of that profit to stock owners. This is a dividend. For example, if you owned 1 share of Microsoft, you would have been paid $1.56 last year.

7. Why do stocks go up or down? The price of a stock reflects what investors think a company is worth. Basically, a company with high profits is worth more than a company with low profits; a company that is growing fast (e.g. Amazon) is worth more than a company that is growing very slowly, or getting smaller (e.g. Target or Walmart). Stock prices fluctuate because companies might grow faster or slower than predicted, causing investors to reevaluate the company’s value. Expectations about corporate profits frequently err by large margins, leading stock prices to fluctuate considerably.

Stock prices also fluctuate due to human nature. During prolonged periods of economic growth, people buy more and more stocks, causing stock prices to rise. As prices go up, people become euphoric and invest more, and the market continues its increase until eventually stock prices bear little resemblance to the actual profits of the companies being traded. Then the cycle reverses itself: people realize stocks are too expensive, investors rush to sell at the same time, and prices collapse. In this respect, investing in stocks sometimes resembles investing in beanie babies, stamps, wine, or similar items.

8. What is a bond? A bond is a loan that investors make to companies or the government. For example, the US government frequently issues 10-year treasury bonds. If you buy one of these, you loan the government $100, and the government agrees to pay you $2.50 every year for 10 years, and at the end of the 10th year, you get your $100 back.

9. Why do bonds go up or down? Bonds go up or down either because interest rates change or because investors become worried that the borrower is not going to be able to keep paying interest.

10. What are indexes? An index is a list of companies. For example, the Dow Jones Industrial Average is a list of 30 of the largest companies in the United States. The S & P 500 is a list of the 500 largest companies. The Russell 3000 is a list of the 3000 largest publicly traded companies. There are also indexes for bonds.

11. What are index funds? Companies like Vanguard, Fidelity, and Charles Schwab allow you to buy a fund that invests in the companies listed in an index. Basically, if you invest $100 in Vanguard’s S & P 500 fund, you buy a small piece of each of the companies in the S & P 500.

12. Why own an index fund? Three reasons: 1) extremely low fees; 2) index funds rarely buy or sell companies, making them tax efficient; 3) broad diversification, meaning you don’t have to fret about the prospects of any single company or industry.

II. Trade-Offs

You now know why you must invest, as well as what stock and bond index funds are. Next, you need to understand the tradeoffs that investors make when deciding what to buy. While the below isn’t true 100% of the time, it serves as a useful rule of thumb.

1. Expected Return – this is the rate at which you expect your investment to increase in value.

2. Volatility – this is the degree that your investment might fluctuate in value from one year (or month) to the next. In particular, this is the extent that your investment might lose value over a given period of time.

3. Variability of returns – this is the degree that an investment’s actual returns might differ from an investment’s expected return.

The Tradeoff – Investments with high expected returns tend to fluctuate greatly in value and may return much more or less than anticipated. Investments with low expected returns should fluctuate less in value and offer more predictable returns.

Three examples illustrate this principle. We can use a monte carlo simulator (offered free on-line) to calculate the range of future possible returns of a specific investment.

There is no variability in the outcome: you know what you are going to get (not much).

Example Two: Invest $1000 in an Intermediate Treasury Bond Fund. (Max loss, -16%) (The formatting is off on these, and I don't know how to make them look more comprehensible here. The basic idea is to show the distribution of possible outcomes, and how the asset has actually performed over the past 5, 10 ... years)

Main takeaway: the more an investment is expected to earn, the higher the volatility and less predictable the long term results.

III. Creating a stock-bond mix that is right for you.

Ok, so now you know what stock and bond index funds are, as well as the trade-offs of owning each. What makes finance fun (or at least interesting) is that you can buy a mix of stocks and bonds to create a portfolio that suits your specific goals.

To do this, you need:

1. A rough idea of how much money you’ll need, and when you’ll need it.

2. A rough plan of how much money you will put toward that goal each month.

3. Determine your willingness to invest in stocks, which might lose much of their value. (To invest successfully, you must be willing to buy, and not sell, during stock market collapses).

The third point might be the most important. The more you crave safety from short-term losses, the more you will need to be satisfied with poor long-term results. The more you can bear short-term losses with equanimity, the more money you are likely to have.

Two examples illustrate these principles.

Example 1: Long Term Savings for Retirement.

Goal: Save $1,800,000 over the next 35 years.

Plan: Invest $5,500 today, and $1,000 every month for the next 35 years.

Notice that the more you invest in stocks, the more money you are likely to have in 35 years, as measured by the median outcome. But there is also a much greater range of possible results and you are likely to suffer much larger short-term losses. Conversely, the more you invest in bonds, the less money you are likely to have in 35 years, the smaller the range of future possible outcomes, and the smaller short-term losses.

Also note that the different stock/bond mixes are risky in different ways. The 80/20 mix is risky in the sense that you might lose up to 41% of your money in a short period of time. But it is the safest portfolio insofar as it offers you the best chance of meeting your goal. By contrast, the 20/80 portfolio is the exact opposite: it is safe in the sense that you risk little short-term loss, but extremely risky given that you have only a slightly better than even chance of reaching your long-term goal.

Once again, the greater amount invested in stocks, the greater the median return, the wider the range of potential outcomes, and the greater the risk of short-term loss. The higher the amount invested in bonds, the lower the median return, the smaller the range of potential outcomes, and the smaller the risk of max loss.

Note that the 20/80 portfolio not only had the smallest potential short term loss, it was also the only strategy that gives a >90% chance of meeting the short-term goal. The cost of that protection is that you give up the potential gains that come with owning more stocks. (Life is uncertain: had you invested using the 20/80 portfolio over the last five years, you wouldn’t have come close to meeting your goal. Such is life).

IV. The How-To of Investing

Great, so now you know what stock and bond index funds are, the trade offs of owning each, and you know how to combine them to suit your particular goal. The next step is to actually open an investment account and buy the funds.

1. Set up an account at Vanguard. This is easy to do, and will only take a few minutes.

2. Decide if you want to open a taxable account, Tax-Advantaged account, or both.

a. Taxable account – In a taxable account, you can sell your investments at any time, and transfer the proceeds to your checking account. It is called a taxable account because the government will tax all earnings.

b. Tax-Advantaged – In a tax-advantaged account you can’t sell your investments for cash until you turn 59. In return for agreeing to not sell your investments, the government agrees not to tax the earnings. It’s a way for the government to encourage people to save for retirement. Examples are Roth IRAs and a 401k. (A 401k is only offered by an employer; you can invest in a Roth IRA yourself).

• Total Stock Market Fund – Invests in every publicly traded company in the United States. (We use this fund).
• SP 500 Fund – Invests in funds listed in the S & P 500.
• Dividend Fund – Invests in companies that pay a decent portion of the earnings as a dividend.
• Global Fund – Invests in publicly traded companies both in the US and abroad.

ii. Good Vanguard Bond Index Funds (Choose One)

• Total Bond Market Fund – Tracks the US bond market.
• Intermediate Treasury Fund – Invests in bonds issued by the Federal Government.
• Intermediate Fund – Invests in bonds issues by corporations and the Government (We use this fund).

b. Option 2: Vanguard Lifestrategy funds. These funds have stock/bond allocations that align with different goals. For example:

ii. Lifestrategy Moderate Growth Fund – 60% stocks, 40% bonds. (Good fund if you don’t know how well you could stomach a large drop in your investment’s value)

iii. Lifestrategy Conservative Growth Fund – 40% stocks, 60% bonds.

iv. Lifestrategy Income Fund – 20% stocks, 80% bonds. (Recommended for any goal within the next 5 years)

4. Set up automatic investments. Vanguard lets you automatically invest at regular intervals. You can therefore automatically invest, say, $250 every other week. The best way to ensure that you don’t sell after a large drop in your investment’s value is to automate your investments and not follow market-news.

5. When can I access my money? If the money is in a Roth IRA, you can’t withdraw it until you turn fifty-nine. If it is in a taxable account, you can withdraw it whenever you want, but will have to pay taxes on any earnings.

If you don’t feel comfortable doing this on your own, there are online robo-advisors at wealthfront.com, betterment.com, or Schwab Intelligent Portfolios that will construct a portfolio based on your goals. One negative is each charges a small annual fee.

Gosh, I think that is a pretty darn good article. I don't think I have ever seen in any of the investing books that much needed content in that short a dissertation.

One thing that seems missing is in the discussion of How To the issue of what stock/bond allocation. A review of Larry Swedroe's principle of need/ability/willingess would serve well here.

I am particularly impressed that the discussion of return and variability of return is up front and explicit. This may be the single most important and usually the single most skipped over/not accomplished concept in the whole thing.

5. What is a stock? A stock is ownership in a publicly traded company, like Facebook, Microsoft, Apple, or General Motors. The benefit of owning a stock is that when the company is profitable it will pay some of its profits to the owners.

I agree with Ladygeek that it is too detailed for a beginner.

That said, I'd change #5 above thus: "it will pay..." --> "its underlying value will go up and it may pay...".

One thing that is amply evident on this board is that investing is a subject that may be fairly simple but can't be made simpler than it really is. All the other material I have seen that we could refer someone to is longer and more detailed than what was posted here, as in the Wiki, the books we recommend, the tens of thousands of posts on this forum, and so on.

If you don’t feel comfortable doing this on your own, there are online robo-advisors at wealthfront.com, betterment.com, or Schwab Intelligent Portfolios that will construct a portfolio based on your goals. One negative is each charges a small annual fee.

One large positive is that an investment adviser will keep her from doing the wrong thing. You're missing a very important point:

"Never do business with friends or relatives. You'll lose your friend and can't get rid of your relatives."

If your sister takes your advice, even in the most minor way, you will be blamed if the market value drops. It doesn't matter how much or when, you will always be blamed.

The best you can do is to educate her and see if she learns this on her own. The next best is to let someone else handle it for her until she gets comfortable with investing. You'll always be there to answer her questions, of course.

Thank you for the feedback! When I was in her position - finally working and with student loans paid off - two years ago, I knew nothing about finance and had no idea what to do with my savings. A colleague pointed me to this community; you have been great teachers. Thank you.

As evident from my intro, and from your comments, the thing I've struggled with the most is walking the line between too much information and oversimplification. Especially with respect to the charts: I thought they made things easier to understand; my partner said they made her eyes glaze over.

One large positive is that an investment adviser will keep her from doing the wrong thing. You're missing a very important point:

"Never do business with friends or relatives. You'll lose your friend and can't get rid of your relatives."

If your sister takes your advice, even in the most minor way, you will be blamed if the market value drops. It doesn't matter how much or when, you will always be blamed.

I don't know why this hadn't occurred to me. Heck, now that I think about it there are an endless number of ways I could be blamed, even if things go great ("the market is only up 50%, I could have tripled my money by investing in bitcoin"). I don't think that will be a problem, but you never know. I think this point counsels heavily in favor of general education, not specific advice, and steering her toward a robo-advisor.

Also, I almost stopped reading on this; "whether social security continues."

Do you really want to use fear, uncertainty and doubt as your beginning introduction to investing?

I will have to think about this. I wasn't trying to use fear, though I was definitely trying to highlight the uncertainty of what will happen in the future. I put the retirement bit at the beginning because most people seem to greatly underestimate the amount they need to retire. And although the actual calculation assumes SS still exists, I wanted her to understand a few reasons that she might need more.